Forecasting Oil Prices

A little humility is in order when it comes to forecasting hydrocarbon prices.  Despite the confident talking heads on television, newsletters and e-mails that promise to forecast prices accurately, and prognostications from government agencies, no one knows what oil and gas prices are going to do.  And if anyone did know, he certainly would not be talking. 

As a result, prices are usually the least predictable element in the economic forecast; and therefore, they usually have the greatest impact on returns.  What is an analyst to do?

The academic literature gives some guidance on the subject.  First, it is important to note that oil and natural gas prices behave differently.  In fact, this should not be a surprise since, even though they occur together in nature, oil and natural gas have very different uses and are mostly not substitutes for one another.  So we will tackle oil prices first.

Second, forecasting methods that had the most predictive power in the 1980s and 1990s have not continued to be the best over the last ten years.  It appears that the factors that drive the price of oil change over time.  So even if we apply the findings of academic studies from the last decade, their conclusions may not be applicable over the next decade, which would be the time frame when our wells would be producing.

Recent studies have found that at time frames of 1-3 months, adjusted futures prices have the most predictive power.  But in new investments, this is almost always the preparation period when agreements are made with governments and landowners, engineering is done, and equipment is mobilized.  So futures markets are of little use in preparing price forecasts for project acquisitions, but they could be useful for analyses of producing fields.  And they should be more useful for fields that decline rapidly, such as shale.

For time frames of 12 months and longer, today’s spot price of oil has the greatest predictive power, although it is a fairly weak predictor.  If I had to guess the price of oil a year from now, I would guess today’s spot price, although it very likely could be something else.

How should we tackle a critical problem where the data we can observe provide weak guidance?  One common, although particularly bad practice, is to take today’s spot price and escalate it at some rate of inflation until it reaches a ceiling.  There is no evidence that oil prices tend to escalate in this manner.  Rather it represents the industry’s dream that oil will again reach its “natural level” of $140 and stay there.

A good practice is to present a base case with a constant-price forecast of today’s spot price.  (If a large portion of the production will come in the next 3-6 months, consider using an adjusted futures forecast for those months.)  I then present several alternative cases with a range of prices.  If a client is using debt-financing for the investment, I would focus attention on the worst-case scenarios to help them think about whether they can survive a sharp drop in oil prices.  And I compare the spot price to the range of historical prices to help the client visualize how much potential upside and downside there is.  The best you can do is to provide a number of price scenarios and think about the likely effects of each one on the investment.

Next time, gas prices.